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The Covid-19 pandemic will have a deep and multipronged impact on our lives. Social distancing, masks, and the work from home (WFH) mode have become the new normal. On the economic front, in response to the far-reaching consequences, the government and regulators brought out a comprehensive stimulus package and various policies to deal with this black swan event. The new ecosystem is possibly going to change the way commercial banks handle working capital funding, which forms the major portion of their credit portfolio.

The appraisal of the working capital facilities essentially involves the assessment of the liquidity and solvency aspects of the borrower (with a plethora of mathematical ratios like current ratio, leverage ratio etc.) and its business plans. The present mechanism primarily entails the ‘Asset Based Lending’ system where the projected levels of holdings of the stocks (raw material, stock in process and finished goods) and debtors (receivables) become relevant. These levels adjusted for the purchases made on credit basis determine the ‘Drawing Power’ or the extent to which one can withdraw and avail funds from a bank. The overall credit facility is calculated on the basis of the turnover method or the maximum permissible bank finance (MPBF) method. These time-tested assessment mechanisms and norms are going to be under severe pressure in the present scenario.

With the lockdown resulting in stoppage of production/ trading activities, a situation has arisen leading to a likely shrinkage of the economy. This implies lesser goods and services produced and assets created with no corresponding reduction in the working capital banking credit liabilities. Rather, this liability increases with levying of interest over time (the moratorium gives only a temporary reprieve).

The ‘Drawing Power’ calculated based on the value of assets (stocks + receivables) will be less than actual outstanding bank liabilities in most of the cases which have been impacted by the lockdown. Deferment of payments, conversion of irregular portions of borrower’s account into long term loans are only ad hoc solutions and deep restructuring of the accounts may be ultimately required.

The additional working capital financing provided by commercial banks in most cases is meeting immediate liabilities of essential expenditure and not creating any additional asset (which in normal circumstances is an essential requirement for permitting the additional funding). The need for survival has led to this situation.

This however, opens the way for an underlying change and opportunity to shift to the ‘Transaction Based Lending’ system instead of ‘Asset Based Lending’ system. This essentially implies that cash flows of the business - both inward flows (sales, realizations, fresh induction of funds by promoters etc.) and outward flows (purchases, expenditure, payments etc.) become the basis of funding instead of the value of assets. The ultimate criteria of ‘viability of the business’ shall however continue to be applicable whereby the business needs to be profit generating to pay the bank’s interest and reasonable returns to the promoter. The quantum of withdrawal of funds from the bank will be determined by cash inflows and cash outflows of the business and not by fresh creation of assets.  Such a model is already in vogue in infrastructure funding, particularly in the road sector, where the lending is primarily against future cash flows of the business and not against assets.

Monitoring and overseeing the ‘Transaction Based Lending’ system shall be more complex. But given the technological tools already available and those evolving including Artificial Intelligence (AI), this mechanism may ultimately be found to be more efficient and effective leading to a win-win situation for all stakeholders.

The author is the former CGM_CFO, Oriental Bank of Commerce and the former CGM, IIFCL.